5 Myths About Inflation

Are you frustrated that you are paying more for basically everything today compared to last year? 2021 saw one of the highest inflation rates in recent memory, and it’s continued into 2022.

With such high inflation, many people have been giving their 2 cents on the issue. Or maybe it would be 3 cents by now if we don’t adjust for inflation. With it, a number of inflation myths have spread.

Let’s take a closer look at what inflation is and five common misconceptions of how it works and what it does.

What is Inflation?

Inflation is a loss of purchasing power over time. This means that your dollar will not go as far as it did last year. An example would be a meal at your favorite restaurant costing you 5% more today than it did a year ago. You get the same product or experience, but you have to pay more money for it.

This should be concerning to people, especially if their incomes are not increasing over time. If you make the same amount of money this year compared to last year, you will be able to afford less and less.

No one person can control inflation. Several factors play into it. Several do not. Let’s go over some of the more popular myths out there and see what we can learn.


5 Myths About Inflation

Myth 1: Inflation Occurs Naturally

This myth states that if the entities that control the currency stopped, we would continue to see inflation over the long run.

As pointed out by famous economist Milton Friedman, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

That is, inflation is the result of more money chasing the same or fewer goods.

And it doesn’t only occur in a fiat currency.

For example, during the European conquest of the New World, huge amounts of gold and silver were extracted and then poured into the European economies.

Spanish Conquest of New World
Cortes’s conquest of the Aztecs. Following the conquest of the New World, European colonizers exported many tons of gold and silver back to Europe.

Prices rose substantially during that time, despite currencies being tied to the commodity itself.

Increase in Inflation in England from 1300 to 1700
Increase in Inflation in England from 1300 to 1700. Note the stark increase in the 1500s and beyond following the European conquest of the New World and the subsequent influx of gold and silver.

That’s because the supply of money, despite being a commodity, increased significantly. When that happened without a simultaneous increase in the supply of goods, prices rose.

“Hard” currencies (currencies backed by some commodity) are vulnerable in other ways as well.

For example, many times through history have governments debased their currencies by shaving off metal from coins or by using inferior materials when minting new coins.

Roman Coin Debasement
Roman coin debasement. Source: https://www.visualcapitalist.com/currency-and-the-collapse-of-the-roman-empire/

The result is the same: each currency unit is effectively worth less than before. Inflation follows.

What About Psychology?

But what if consumers expect inflation and start paying more for things now?

If most people believe that prices will only rise in the future, then they will be more likely to spend more money today (even taking on debt after emptying their savings) to secure a perceived lower price.

That debt would cause an increase in the money supply in the market that could outpace the supply of goods.

However, eventually there’s a breaking point for as to how much people will pay. Unless the money supply increased, prices won’t increase indefinitely. And eventually people will run out of savings to spend or the ability to take on more debt, all else equal.

Not to mention, once they start paying back their debt, that will have the opposite effect on inflation.

So, yes, psychology can play a role in short-term price increases. But, long-term, it still primarily comes down to the money supply compared versus the supply of goods.

Myth 2: Unemployment and Inflation are Opposites

Many people believe that unemployment and inflation cannot go in the same direction.

If this were true, then as unemployment declined, prices would increase. Or if unemployment increased, we would see deflation.

However, history has already shown us that this is not the case. During the 1970’s the US saw an infamous period of stagflation.

On the graph below, you can see that unemployment and inflation are not closely correlated. Unemployment remained around 6% and there were some periods where unemployment and inflation rose sharply at the same time.

US Unemployment vs. Inflation 1970s

If inflation truly was the opposite of unemployment, you’d expect the lines to move proportionately against each other. Instead, during the 1970s, they often rose and fell in the same direction. Both inflation and unemployment ran exceptionally high.

Thus, inflation and unemployment are not opposites, as we already have a notable counter example.

Myth 3: (Some) Inflation is a Good Thing

A common misconception is that inflation implies the economy growing. Inflation simply means that the money supply has been growing. And it’s growing beyond the output of the economy.

This is only a good thing for a very specific type of person.

Inflation can be good for a debtor. For example, if you are a real estate investor, you may have properties on debt that is long term on a fixed rate. With inflation, the price of the properties will generally increase, while the value of the debt will not.

As time passes and inflation occurs, an investor can profit off the appreciated value by using that increased value of the property, or the likely increased rental income, to pay off the debt. The investor is using devalued currency to pay back the debt.

This is inflation induced debt destruction.

However, compare that investor to a retiree on a fixed income.

For the retiree, inflation isn’t a good thing.

The cost of living increases so the retiree will have to allocate more money annually to purchases such as groceries to maintain his or her lifestyle. But that retiree’s income is fixed, or mostly fixed.

The result is pain.

Myth 4: Deflation is a Bad Thing

Deflation is the opposite of inflation. With deflation, we see falling prices. Is deflation bad?

Whether or not deflation is a “bad thing” depends on the type of deflation occurring.

An example of “bad” deflation is debt destruction through defaults. When people default on their debts and file for bankruptcy, creditors will stop issuing new debts or increase interest rates.

Similarly, if a central bank like the Federal Reserve wants to combat inflation, it will often increase interest rates in the economy. The cost of borrowing increases, so less debt is created. And anyone on a variable rate loan will likely face higher rates, thus destroying that borrower’s, or potential borrowers’, purchasing power.

That’s bad deflation. It’s sometimes necessary to clear out bad loans and bad decisions, but it’s incredibly painful to go through (think the beginnings of the Great Depression and the Great Recession in the US).

But prices falling can be a great thing.

For example, companies may become more efficient at producing things, allowing them to lower the price of many products, or otherwise create more of them.

Having a lower price point on a product allows more people to buy it. Even if wages remain stagnant, more people would be able to afford those cheaper goods. And more businesses could afford those things too, thus lower their costs, and so on.

Even if wages decrease at the same time, if the decrease is smaller than the decrease in the costs of goods, purchasing power increases and the standard of living increases as well.

One of the greatest examples of this happened in the latter half of the 1800s.

U.S. Inflation and deflation from 1775 to 2015.
US inflation and deflation from 1775 to 2015. Note the significant period of deflation from the 1860s until the early 1900s. Source: https://mutualfundobserver.com/discuss/discussion/24817/a-brief-history-of-u-s-inflation-since-1775-wsj-real-time-economics

Deflation was significant. Yet the increase in the standard of living was tremendous.

Goods became cheaper and wages increased in real terms.

The average person’s life became dramatically better.

Simply put, deflation due to productivity growth is almost always a good thing.

Myth 5: A “____” Standard is the Solution

This myth assumes that a gold or a bitcoin standard can solve the issues caused by inflation.

There is no perfect money system.

Even in a system where the currency is backed by a commodity, like gold, the price of the commodity itself can still be manipulated.

We saw this a number of times throughout history, including in 1934 when President Roosevelt signed the Gold Reserve Act of 1934, statutorily fixing the price of gold while transferring all ownership of gold in the US to the US Treasury.

FDR signs the Gold Reserve Act of 1934 into law
FDR signs the Gold Reserve Act of 1934 into law.

Simply put, a commodity-backed currency can still be manipulated.

Thanks to this threat of centralized manipulation, many people advocate for “decentralized finance,” where the monetary system is facilitated by individuals or small groups rather than large institutions and governments. They’ll often advocate for specific cryptocurrency projects that can allow for this.

In a decentralized money system, there is very little recourse for mistakes or fraud. After all, there’s no centralized help line to call. But the threat of a central body manipulating the system is low if not impossible. It’s a tradeoff.

And, even in a “hard” currency system, inflation can still occur. We saw the example with the influx of gold and silver into Europe during the conquest of the New World. Or the US government statutorily changing the price (and ownership rights) of gold.

Similarly, lenders can still create new debt within a hard currency system, and the currency can be manipulated by a central bank or government.

Each system has its benefits and flaws. There is no invincible monetary system, and none without at least some significant issues.

Conclusion: The Truth About Inflation

The bottom line is that inflation depends on the money supply. At the same time, inflation is not always a good thing, and deflation is not always a bad thing.

2021 saw one of the highest inflation rates we have had in recent memory. 2022 isn’t looking any better.

The most important thing is to have a plan for your money so that money problems do not simultaneously inflate.

This website, and any communication stemming from it, while hopefully informative, should not be taken as financial or legal advice. Assume all links are affiliate links. I am an Amazon affiliate.

Jack Duffley

Jack Duffley is a real estate investor and attorney based in Houston, TX.

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